Thrift
is the Future: Interventions will only Prolong the Credit Crisis

London, UK - 11th December 2008, 15:58 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors
are not necessarily representative of the views of ATCA, which is neutral.
ATCA conducts collective Socratic dialogue on global opportunities and threats.]

We are grateful to David Roche, President and Global Strategist
at Independent Strategy, London, for his contribution to the ATCA Socratic
dialogue on The Great Unwind. He writes:

Dear DK and Colleagues

Let us state it bluntly. If recessions are to be judged by their length
and depth, the current policies of the American, British and French governments
will not make the global economic recession any less painful. They may make
it less deep, but they are equally likely to prolong it. Fiscal stimulus
and lax monetary policy will help avoid debt deflation and depression. But
many of the measures taken to "save" the financial system will
prolong credit contraction and the recession and leave the financial system
permanently impaired.

That is because the underlying cause of the great global credit crunch is
the ingrained societal behaviour of the US and many other economies over
the past two decades: instant gratification of "needs" without
reference to the ability to earn the satisfaction of doing so. This did
away with the economic virtue of thrift and encouraged excessive consumption.
Excessive consumption resulted in global imbalances such as the US current
account deficit.

The trigger for the collapse was the bursting of the credit bubble that
funded the leverage, the asset price inflation and the global consumption
boom. But the immediate cause of the crisis cannot be addressed without
dealing with the underlying cause too. Any attempt to prolong the credit
party will simply prolong the disease.

The correct method to deal with credit crises is not rocket science. It
is as well tried and original as the recipe for instant soup. It was first
etched in stone by the Scandinavians in the early 1990s. But it is being
applied nowhere.

The UK model comes closest. But it too lacks the essential ingredient: forcing
the banks to write down their assets to market and take the hit to shareholder
capital before recapitalisation begins. Without this, there is no way of
knowing how much capital is needed and no telling which institutions are
solvent or distinguishing between good and bad banks.

In the US, about 90 per cent of all the measures to deal with the credit
crisis aim to prevent asset prices falling to market levels, at which they
would clear. The balance sheets of borrowers and creditors will remain encumbered
by dud assets and liabilities, slowing the resumption of credit expansion
and risking stagnation of the process of intermediation between saving and
investment.

A substantial proportion of the fiscal measures enacted and planned, as
well as the initiatives to restructure mortgages either through private
sector banks or government-sponsored entities, are intended to bail out
borrowers and prevent the repossession of houses. This will stop the ultimate
cause of the crisis, lack of household thrift, being addressed rapidly.
Such measures train the Pavlovian dog not to learn new ways when that is
precisely what it needs to do.

What the world economy needs is reduced leverage. To avoid similar credit
crises in the future, thrift must replace leverage and scarcer capital has
to be invested more productively. Policies that deviate from this aim are
bad. Thus replacing excessive private sector leverage with inefficient and
market-distorting state leverage is not a path to a more stable world.

It is a matter of simple arithmetic to work out that the new layers of state
debt to deal with the credit crisis are not a substitute for private debt,
but an addition to it. This is because the state debt does not extinguish
the private debt, but merely finances it, so increasing the layering of
leverage that lies at the heart of the credit crisis.

Worse, bigger budget deficits and borrowing requirements will increase the
US and the UK need for foreign capital. The foreign funding may not be forthcoming,
which could cause the dollar to crash. The increased role of the state will
crowd out more productive uses of capital and create a bigger bureaucratic
role in the economy.

Historical precedent is often the forecasting tool of the mediocre mind.
The deflation periods of 1929 in the US and Japan's post-bubble period are
not accurate forecasts of where we are destined. We have created our own
very serious, but quite unique, mess. Fiscal stimuli and the creation of
central bank liquidity, unless rapidly reined in when the economy starts
to recover, will generate inflation and low productivity growth down the
road.

David Roche

[ENDS]

David Roche is President and Global Strategist at Independent Strategy which
he founded in 1994. Well known for his original and provocative ideas, he
was the first to move away from investment strategy as parochial country
allocation and to focus on investment themes, based on fundamental long-term
analysis, backed up by strongly held convictions. He has forecast some of
the major 'turning points' in global investments of the past 20 years such
as the demise of the Soviet Bloc and the subsequent fall of the Berlin Wall,
or the sharp monetary tightening which heralded the financial reversal in
world bond markets in 1994. Early in 1997 his was the lonely voice, which
predicted the development of the Asian crisis. In February 2000 he advocated
switching out of the over-stretched technology sector into more traditional
companies who would benefit from "new economy" productivity improvements.
Since mid 2006 he has developed and expanded the theory of New-Monetarism
which forms the basis of the credit crunch which we are currently experiencing.

Until 1994, David Roche was Head of Research and Global Strategist at Morgan
Stanley. He holds an MA from Trinity College Dublin and an MBA with the
highest distinction from INSEAD. He is also a Chartered Financial Analyst
and has a diploma in accounting and finance from the UK's Association of
Certified Accountants. David Roche contributes regularly to the Financial
Times, the Wall Street Journal and other top financial publications. He
is also a regular commentator on the BBC, CNN and CNBC television networks.
David's pioneering work on Liquidity and the Credit Crunch is explained
and discussed at length in his recently published book: New Monetarism.

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